One way to generate a second income is by earning dividends from shares. If I was able to put £20,000 into a Stocks and Shares ISA today to try and earn £1,700 annually in dividends, here is how I would go about it.
In allocating the money, I would stick to some basic investment principles.
One is reducing my risk by diversifying across different shares. With £20,000, I could split the money evenly across five to 10 different companies.
Another is focusing on quality companies that are proven dividend payers.
Ideally I would like to invest the Stocks and Shares ISA and then largely forget about it, except for receiving a steady stream of dividends. Past performance is not a guide to what will happen in future. But hopefully, a strong focus on quality businesses could let me sleep peacefully. I would only check on my ISA a few times each year to see whether anything had changed to affect the dividend outlook of the shares I owned.
To earn £1,700 in annual dividends from a £20,000 ISA, I would need to achieve an average dividend yield of 8.5%. As that is an average, some shares could have a lower yield, as long as overall I still hit my target.
What sort of blue-chip shares might pay such a yield?
Looking at FTSE 100 shares that currently yield 8.5% or above can give some clues. Such firms include M&G, Legal & General and British American Tobacco.
The reason those companies can currently pay big dividends is because they have a competitive advantage in a sector with large, ongoing customer demand.
When looking for dividend shares to own in my Stocks and Shares ISA, I hunt for those attributes. I also consider the likely future demand picture (for example, falling cigarette sales could hurt British American Tobacco's profits) as well as debt.
The price I pay for a share helps determine the yield I earn. If I overpay and the share price later falls, the capital value of my Stocks and Shares ISA could decline.
With income as my objective, a fluctuating ISA valuation would not bother me. After all, if I hang on to the shares to earn dividends, that would just be a paper loss.
Still, I would prefer only to buy shares at attractive valuations. Finding companies that have strong dividend potential is not enough on its own. I also want to buy them at the right price.
That means I would not necessarily invest all of the £20,000 straight away, although at current valuations I would be happy to buy the trio of FTSE 100 shares above for my ISA if I had spare cash to invest.
I would also look beyond the FTSE 100 to the FTSE 250. But my focus would stay the same - high-quality businesses with attractive valuations.
The post How I'd use a £20K Stocks and Shares ISA to target a second income of £1,700 per year appeared first on The Motley Fool UK.
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C Ruane has positions in British American Tobacco P.l.c., Legal & General Group Plc, and M&g Plc. The Motley Fool UK has recommended British American Tobacco P.l.c. and M&g Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.